Developed Countries

Highlights The political economy of oil will become even more complicated, following remarks by Russian Finance Minister Anton Siluanov over the weekend, which suggested policymakers there are considering another market-share war to crash prices to limit the growth of U.S. shales. The logic appears to be that by abandoning OPEC 2.0’s production-cutting deal and pushing Brent prices below $40/bbl once again for a year or so, Russia will severely reduce investment flow to the U.S. shale-oil patch, allowing it to retake global market share ceded mostly to Texas oil producers.1 The threat of a market-share war was proffered on top of stepped-up rhetoric by senior government officials – ranging from Igor Sechin, head of state-owned Rosneft Oil, to Kirill Dmitriev, CEO of the Russian Direct Investment Fund (RDIF) – indicating Russia will be pushing for higher production by OPEC 2.0 in 2H19 at the coalition’s upcoming June meeting. We agree with this assessment: The market will require OPEC 2.0 to lift production in 2H19, given our assessment of supply-demand balances. In our estimation, OPEC 2.0’s position has been strengthened considerably by policy-induced disruptions to the oil market.2 As such, we believe Russia’s threat of a market-share war is a feint, particularly since Russia has benefited greatly from higher prices (see below). Our balances and price forecasts this month are largely unchanged (Chart of the Week). We continue to expect Brent to average $75/bbl this year. For 2020, we expect Brent to average $80/bbl. WTI will trade $7 and $5/bbl lower (Chart 2). The balance of price risk has shifted slightly to the left side of the distribution, driven by policy risk and potential miscalculation by the dramatis personae on the international stage, chiefly leaders in the U.S., Russia and China. Chart of the WeekMarkets Continue To Track BCA Balances... Chart 2...While Prices Continue Tracking BCA Forecasts Highlights Energy: Overweight. Tensions in Libya could keep ~ 300k b/d of supply from reaching global markets via its Zawiya port near Tripoli. We closed our long June 2019 $70/bbl vs. short $75/bbl call spread last Thursday with a gain of 87.7%.3 Base Metals: Neutral. China’s latest credit data confirms our view the country’s credit cycle bottomed earlier this year: March Total Social Financing (TSF) increased CNY 2.8 trillion month-on-month vs. consensus expectation of CNY 1.7 trillion. This will support base metals in the coming months. We continue to expect Chinese authorities to expand credit in 2H19.Our long copper trade is up 0.7% since inception on March 7, 2019. We are closing out our tactical iron-ore trade – long 65% Fe vs. short 62% Fe at tonight’s close; it was up 22.9% at Monday’s close. Precious Metals: Neutral. Gold fell 4% from its February high on easing inflation concerns and as fears of an equity correction subsided. March U.S. PCE ex-food and -energy dropped to 1.79% yoy from 1.95% in February, while global equities rose 14% YTD. Our long gold recommendation is down 2.4% since last week, but is still up 3.6% since inception on May 4, 2017. Agriculture: Underweight. U.S. corn and wheat farmers are behind schedule in their spring planting, according to USDA data. The top four American corn-producing states had not started planting by last week, while spring and winter wheat producing states are 11% and 3% behind schedule, mostly due to weather conditions. While delays in planting are always cause for concern, we are still early in the planting season, which gives farmers time to catch up. Feature Policy uncertainty vis-à-vis global oil supply was elevated by Russian Finance Minister Anton Siluanov’s comments indicating policymakers are considering reviving an oil market-share war directed at U.S. shale-oil producers. Siluanov said prices could fall to $40/bbl or less, in the event. Russian President Vladimir Putin, who, among the policy elites of Russia, remains primus inter pares, has indicated he is satisfied with prices where they are now His remarks come on the back of statements from Russian government and oil company officials lobbying for higher output. These comments suggest there is a heavyweight Russian contingent fully supporting these demands for OPEC 2.0 to increase production in 2H19 when it meets in June. Otherwise, the threat implies, Russia will seriously consider leaving OPEC 2.0, and will launch its own market-share war against U.S. shale-oil production, led by the fast-growing Permian Basin in Texas. Thus far, Russian President Vladimir Putin, who, among the policy elites of Russia, remains primus inter pares, has indicated he is satisfied with prices where they are now – nicely above $70/bbl in the Brent market. He also wants to maintain cooperation with OPEC 2.0, particularly its other putative leader, KSA. We continue to believe, however, KSA and Russia become less comfortable with Brent prices moving sharply above $80/bbl.4 Nonetheless, the threat posed by the U.S. shales is non-trivial: In our latest balances estimates, we raised our 2H19 U.S. output estimates to 12.53mm b/d, and slightly decreased our 2020 estimates to 13.35mm b/d”, led by a 1.17mm b/d and 0.84mm b/d increase in shale output this year and next (Chart 3). Chart 3U.S. Oil Production Estimate Higher For Shales However, Russia – and OPEC 2.0 generally – may be overestimating the rate of growth from U.S. shales going forward: In future research, we will be exploring the extent to which capital markets will restrain growth in the U.S. shales, as investors continue to demand higher returns. The days of growing shale production at any cost may be coming to an end. Russia’s Threat Is A Feint We believe Russia’s threat of a market-share war is a feint: A market-share war would damage the Rodina’s economy more than the balance sheets of U.S. shale producers, particularly those that hedge the first year or two of their production. The threat needs to be understood in the context of the deterioration of Russia’s position in Venezuela; the increasing tempo of U.S. military operations in its near abroad; and rapidly evolving global oil and gas trade flows, all of which are working against Russian interests and investments.5 The threat appears to be a not-too-subtle reminder of the havoc Russia still can create globally, should it choose to do so, as Vladimir Rouvinski noted recently re Russia’s Venezuela policy.6 Russia almost surely is better off under the production-cutting regime launched by OPEC 2.0 than it would be in another price war. Russia’s GDP elasticity to oil prices is more than twice that of KSA’s, which we demonstrated last week.7 This means, from an economic standpoint, it benefits more from higher prices than the Kingdom, based on our modeling. Russia’s oil is exported to refiners and trading companies who pay whatever price is clearing the market, versus KSA, which relies more on direct investments in end-use markets to serve captive demand, and whose GDP has a higher sensitivity to EM economic growth. Russia almost surely is better off under the production-cutting regime launched by OPEC 2.0 than it would be in another price war. The coalition’s production-cutting deal this year has reduced global supplies by 1.0mm b/d since the beginning of the year, lifting price from below $50/bbl to more than $70/bbl, in line with our forecast. These production cuts have been supported by strong global demand this year this, which, we expect, will persist in 2020. Of course, Russia could abandon the production-cutting deal with KSA, in the hope of severely reducing investment in U.S. shale-oil production. However, it also would accelerate the loss of foreign direct investment (FDI) in its own hydrocarbons sector, along with those of other OPEC 2.0 member states (Chart 4). Bottom Line: A Russian market-share war aimed at U.S. shale producers would run the very real risk of tanking Russia’s GDP and those of the rest of OPEC 2.0’s member states, as these economies lack the resilience and diversification of the U.S.’s GDP, particularly Texas’s. Even if its fiscal balances are in better shape now, Russia’s economy remains highly sensitive to Brent crude oil prices – moreso than KSA’s, and far moreso the U.S.’s (Chart 5).8 Chart 4Another Oil Market-Share War Would Crush OPEC 2.0 In-Bound FDI Chart 5Russia Benefits More Than KSA From Higher Oil Prices BCA’s Balances Mostly Unchanged Our updated balances reflect the lower Venezuelan and Iranian output reported by OPEC’s survey of secondary sources (Table 1). As we have noted previously, we believe OPEC 2.0’s spare capacity is sufficient to cover the loss of Venezuelan output, and the limited losses on Iranian exports imposed by U.S. sanctions (Chart 6). Beyond that, however, the market will be severely stretched if an unplanned outage removes significant production from global supply. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) On the supply side, we continue to expect OPEC and Russia to lift supply in 2H19, following the successful draining of global inventories (Chart 7). We expect OPEC ex-Iran, Libya and Venezuela, led by KSA, will lift 2H19 supply by ~ 400k b/d vs. 1H19 levels, while we expect Russia’s output to rise 200k b/d. Chart 7Lower Inventories Require OPEC 2.0 Supply Increase In 2H19 We continue to expect oil demand to be supported by the renewed easing of monetary policy globally, which will redound to the benefit of EM demand, which also will benefit from the bottoming of China’s credit cycle. Indeed, the EIA added 130k b/d to its estimate of non-OECD demand for this year, on the back of stronger expected growth. We expect demand growth of 1.5mm b/d this year and 1.6mm b/d next year, with EM growth accounting for 1.1mm b/d of growth this year and 1.3mm b/d next year. In levels, global demand will average 101.8mm b/d and 103.4mm b/d in 2019 and 2020. Waivers On U.S. Iran Sanctions Will Be Extended We continue to expect waivers on U.S. sanctions of Iranian oil imports will be extended on May 2, owing to the still-tight supply conditions globally with Venezuela output collapsing and ~ 1mm b/d of Iranian oil already forced off the market. This has, as we’ve noted in our discussions of the New Political Economy of oil, strengthened OPEC 2.0’s hand. This will become apparent when the coalition meets in June to consider whether to increase production in 2H19, in line with our expectation. KSA, Russia and OPEC 2.0 member states will have sufficient data on hand to determine whether and by how much to lift output, in a manner that supports their GDPs. Indeed, on Wednesday, Russian Energy Minister Alexander Novak said, “We should do what is more expedient for us.”9 KSA and Russia appear to be managing production in a manner consistent with our forecasts of $75 and $80/bbl for Brent this year and next than not. We also expect U.S. President Donald Trump to try to jawbone OPEC 2.0 into increasing production again, as he did in 2H18. However, we expect those demands to fall on deaf ears, unless fundamental supply dislocations warrant such action. Bottom Line: OPEC 2.0’s strategy is working – it will have maximum flexibility re how it handles its production in 2H19, following the U.S. decision on waivers to its Iran oil-export sanctions on May 2. As we noted last month, KSA and Russia appear to be managing production in a manner consistent with our forecasts of $75 and $80/bbl for Brent this year and next than not.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com     Footnotes 1      OPEC 2.0 is the name we coined for the OPEC/Non-OPEC oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia.  It agreed in November to remove 1.2mm b/d off the market, in order to balance global supply and demand and reduce inventories.  Please see “Russia, OPEC may ditch oil deal to fight for market share: Russian minister,” published April 13, 2019, for a re-cap of Siluanov’s remarks. 2      Please see “The New Political Economy of Oil,” published by BCA Research’s Commodity & Energy Strategy February 21, 2019; and “OPEC 2.0: Oil’s Price Fulcrum,” published March 21, 2019.  It is available at ces.bcaresearch.com. 3      Please see “Oil steadies as market focuses on supply risks,” published April 15 2019 by reuters.com 4      Please see “Putin Says No Imminent Decision on Oil Output Cuts,” published April 10, 2019, by The Moscow Times. 5      Please see for example, “Pentagon developing military options to deter Russian, Chinese influence in Venezuela,” published by cnn.com April 15, 2019; “Destroyer USS Ross Enters Black Sea, Fourth U.S. Warship Since 2019,” published by news.usni.org April 15, 2019; and “U.S. LNG exports pick up, with Europe a major buyer,” published by reuters.com March 7, 2019. 6      Please see “Russian-Venezuelan Relations at a Crossroads” by Vladimir Rouvinski, published by the Wilson Center’s Kennan Institute in its February Latin American digest. 7      Please see “Sussing Out OPEC 2.0’s Production Cuts, U.S. Waivers On Iran Sanctions,” published by BCA Research’s Commodity & Energy Strategy April 11, 2019.  It is available at ces.bcaresearch.com. 8      We discuss the impact of higher oil prices on Russia’s economy in last week’s report, which is cited in footnote 6 above.  Russia’s GDP in 2017 was ~ U.S. $1.6 trillion, according to the World Bank, while the GDP of Texas was ~ $1.7 trillion, American Enterprise Institute. 9      Please see “Russia’s Novak: early to speak about options for oil output deal,” published reuters.com April 17, 2019. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 ​​​​​​​ Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Overweight The S&P oil & gas exploration & production (E&P) index received a much needed boost last week when the blockbuster acquisition of Anadarko by Chevron (at a 37% premium to the stock’s previous close) was announced, triggering a wave of M&A premia being added to stocks in the index. This valuation lift looks reasonably well deserved in our opinion, considering the degree to which the integrated oil majors are moving in to shale gas plays with a focus on the Permian basin. A narrowing of junk bond spreads is confirming the resurgent optimism in the sector (second panel). Our investment thesis is based on our sister publication, BCA’s Commodity & Energy Strategy, and their bullish WTI view, which is the fundamental growth driver in the sector (WTI shown advanced six months, bottom panel). We continue to expect a recovering energy price to drive a reversal of the recent moderation in oil & gas production, delivering a double dose of growth and margin improvement, goosing sector earnings and share prices. Bottom Line: We reiterate our overweight recommendation on the S&P oil & gas E&P index and our high-conviction overweight recommendation on the broader S&P energy index that we added this week.1 The ticker symbols for the stocks in this index are: BLBG: S5OILP - COP, EOG, APC, PXD, CXO, HES, FANG, DVN, MRO, APA, NBL, COG, XEC.   1 Please see BCA U.S. Equity Strategy Weekly Report, “ Show Me The Profits” dated April 15, 2019, available at uses.bcaresearch.com.

Special Report

Dear Client, This Special Report is the full transcript and slides of a keynote presentation I recently gave to the Sovereign Investor Institute in London titled: 'The Biggest Risks To The Global Economy Are…' The short presentation pulls together several concepts and observations which identify the ‘weak links’ in the global economy. Therefore, the presentation should serve as a useful summary of the global economy’s current vulnerabilities. The report then explains how each of the risks translates into a European investment context. I hope you find it insightful. Best regards, Dhaval Joshi, Chief European Investment Strategist Feature Full Transcript And Slides Good morning Thank you for inviting me to give today’s keynote presentation under the title: ‘The Biggest Risks To The Global Economy Are…’ (Slide 1). I will not discuss all the risks out there, but the four risks that I will present are the ones that I think are the most significant. And the biggest of these four risks I will leave to the end. So let’s begin. Risk 1 is China’s Credit Cycle (Slide 2). You can see this very clearly in this slide (Slide 3) which shows the short-term accelerations and decelerations in credit within the world’s three largest economies – Europe, the United States, and China. In essence, it is showing how much new credit was created in the last six months compared with the preceding six months. Was it more credit creation or was it less, and how much more or less? Everything is in dollars to allow a fair comparison. Now look at the red line. The red line is China. Just ten years ago, China’s credit cycle was irrelevant. It simply didn’t matter. But after the GFC, China’s short-term credit expansions and contractions suddenly became as large as those in Europe and the U.S. More recently, China’s cycle is dwarfing the others, so now it is the European and the U.S. credit cycles that are irrelevant! This means that whenever China’s short-term credit cycle turns down, as it did in late 2015, early 2017, and 2018, the global economy feels a chill. The point is that this short-term cycle is a near-perfect oscillator. Down-oscillations will occur every eighteen months or so, and any of them has the potential to turn nasty. Though we are currently in an up-oscillation, the next down-oscillation is due later this year. And I predict that it will pose a big risk to the global economy. Risk 2 is Trade Imbalances (Slide 4). This slide (Slide 5) has a mischievous title ‘Where President Trump Is Right About Europe’. The red line shows where the president is absolutely right: Europe is running a massive – a record-high – trade surplus with the United States. It is an undeniable fact. But the president is wrong about the underlying cause. The underlying cause is not unfair trade practices or tariffs, the underlying cause is the other line, the blue line, which shows the divergent monetary policies of the ECB and the Fed. The trade imbalance and monetary policy divergence are moving together tick for tick, and the transmission mechanism is of course the exchange rate. The divergent monetary policies have depressed the euro, and a depressed euro obviously makes German cars cheaper for American consumers. That is the reason that the president is seeing so many BMWs driving down Fifth Avenue! My point is that these record-high imbalances are being used to justify economic nationalism – retaliatory tariffs, restricted trade, and potentially all-out trade wars. Alternatively, this chart suggests that the imbalances would correct with large-scale movements of exchange rates. But to me, either of these options poses a big risk to the global economy. Risk 3 Is Technological Disruption (Slide 6). To understand why, I want to introduce you to a concept known as Moravec’s Paradox (Slide 7). A professor of robotics, Hans Moravec, noticed something odd. He realized that things that we find very hard are actually very easy for AI. Things like complex mathematics, speaking multiple languages, or advance pattern recognition. Typically, as few people have these skills, they are well-paid skills. Whereas things that we find very easy are incredibly difficult for AI. Things like human movement and recognizing, and responding to, emotional signals. Typically, as everybody has these skills, they are low-paid skills.  Moravec’s Paradox means that the current wave of technological progress is much more disruptive than previous waves. The steam engine destroyed low-paid jobs, forcing workers up the income ladder. But the current wave of technology, led by AI, is destroying well-paid jobs forcing workers down the income ladder. You can see it in the data. While job creation in most major economies is on the face of it very strong, just look at what type of jobs are being created (Slide 8). Food delivery, bar work, care work and social work. Now you’ll agree that this is not highly paid work with career prospects!  In essence, the current wave of technology is revealing a huge misallocation of capital. You might have invested huge amounts of time and money in say, becoming a linguist. Only to find that AI can translate languages much better than you – and your employment opportunities are limited to lower-income work. Well that misallocation of capital is very disruptive.  In my opinion, it’s one of the main reasons why even though economies are growing and unemployment is very low, people don’t feel good. Making them susceptible to simplistic fixes such as ‘take back control’ and economic nationalism. My point is that the current wave of AI-led job disruption has much further to run, and the populist backlash will remain a big risk to the global economy. But now I want to turn to what I believe is the biggest risk of all. Risk 4 Is Higher Bond Yields (Slide 9). Most people believe that economic downturns cause financial market downturns. But the truth is the complete opposite: the causality almost always runs the other way! In the vast majority of cases, it is financial market imbalances and mispricing that cause economic downturns and crises. Take the last three economic downturns – in 2001, in 2008 and in 2011. They all had their roots in financial mispricing – the dot com bubble, the U.S. mortgage market, and euro area sovereign debt. Likewise for the Great Depression in the 30s, Japan’s recession in the early 90s. I could go on. You get the point… What is the financial vulnerability today that could cause an economic downturn? (Slide 10) The answer is that the very rich valuation of equities and other risk-assets is highly sensitive to bond yields. Which means that substantially higher bond yields pose a very big risk to the global economy. You see, at very low bond yields, the bond price can no longer go up much but it can go down massively (Slide 11). The latest advances in financial theory now conclusively show that this unattractive ‘negative’ asymmetry is what defines ‘risk’ for investors. The crucial point is that at low bond yields, bonds become as risky, or more risky, than equities (Slide 12). And this necessarily means that equities no longer need to deliver a superior return, a risk-premium, over the low bond yield (Slide 13). As bond yields decline this means equity valuations get an exponential boost because both components of the equity’s required return – the risk-free component and the risk-premium component – are collapsing simultaneously (Slide 14). But if bond yields rise substantially, the process would go into vicious reverse and equity valuations would fall off a cliff. Other risk-assets too, and bear in mind that if we include real estate – as we should – global risk-assets are worth $400 trillion, five times the size of the global economy!   Our research shows that the point of vulnerability is if the global 10-year bond yield approaches 2 percent, which is about 50 basis points above where it stands right now. And that, to me, is by far the biggest risk to the global economy. So to summarise, the biggest risks to the global economy are: China’s credit cycle; trade imbalances and technological disruption and their associated populist backlash; and the biggest risk is higher bond yields (Slide 15). In the near future I think alarm bells should start to ring if China’s credit cycle has tipped into a down-oscillation and/or the global 10-year bond yield is 50 bps higher. Don’t worry, the alarm bells are not ringing right now but they might be later this year. Finally, given the title you gave me, this presentation has necessarily focussed on the key risks. But I don’t want you to get too negative. I also have another presentation called ‘The Biggest Positives For The Global Economy Are…’ And for balance, I hope you invite me to present that next time! Thank you. How Do The Risks Translate Into A European Investment Context? Risk 1: China’s Credit Cycle, is highly relevant to European investors, for two reasons. First, the European economy is very open, meaning that exports make a substantial contribution to GDP growth. This is especially true in Europe’s engine economy, Germany, but it is also important for other major economies like Sweden. And it is evidenced in large trade surpluses as, for example, illustrated in Slide 5. Therefore, whenever China’s credit cycle enters a down-oscillation, as it did last year, Germany cannot escape the nasty chill coming through its all-important net export channel. Second, the European equity market is over-exposed to global growth sensitive sectors and companies – specifically, Industrials, Materials, and Financials. These sectors tend to have a very high operational gearing to global growth. Meaning that a small change in global growth has a disproportionate effect on these companies’ profits and share price performance. The upshot is that in a credit cycle up-oscillation, Europe’s global-growth sensitive stock markets and sectors benefit from a sharp burst of outperformance. The opposite applies in a credit cycle down-oscillation. It follows that if China’s credit cycle is due to tip into a down-oscillation later this year, it would be time to close our successful relative overweighting to European equities and to the global growth sensitive cyclical sectors. Risk 2: Trade Imbalances, is also highly relevant to European investors, for the obvious reason that European economies – especially Germany – are running huge trade surpluses. This puts these economies squarely in the cross-hairs of a retaliatory salvo involving tariffs, trade barriers, or worse, an all-out trade war. Clearly, Europe’s ‘exporting champions’ are the most vulnerable to this risk. The issue is important for the exchange rate too. We showed conclusively that Europe’s trade imbalance is the consequence of the depressed euro. It follows that another way to correct this imbalance is via a stronger euro. In this sense, the fundamentals imply euro upside from here. Risk 3: Technological Disruption, manifests through disruption in the jobs market, the lack of feel good, and the ensuing backlash leading to populism and nationalism. This is particularly relevant to Europe because its collection of nations, each with its own political processes, provides more scope for a political tail-event. A lull in the major political-event cycle is a good thing for Europe. In this regard, the upcoming EU parliamentary elections is not a big risk given the EU parliament’s inability, by itself, to drive policy. The risk increases approaching a meaningful political event, and this includes the date of Brexit. Therefore, this risk is likely to rise somewhat towards the end of the year. Risk 4: Higher Bond Yields, is clearly very relevant to Europe because many of the core euro area bond yields are at their lower bound. This means that the negative asymmetry of returns has its maximum impact on, for example, German bunds. It follows that German bunds are a sell in the near-term. Nevertheless, the upside to yields is ultimately limited given the aforementioned vulnerability of risk-asset valuations to higher bond yields. Therefore, the better long-term strategy is to short German bunds relative to U.S. T-bonds. Finally, a 50 basis points rise in 10-year yields from current levels would be a trigger to flip to underweight European equities.  Fractal Trading System* Crude oil is at a technical reversal level. The best way to play this is on a hedged basis versus metals: short WTI, long LMEX. Set the profit target at 5 percent with a symmetrical stop-loss. In other trades, we are pleased to report long AUD/CNY achieved its profit target at which it was closed. This leaves five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations   Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Going long Treasurys/short bunds has been a “widow maker trade” for the past decade. Similarly trying to short the SPX has also proven impossible since March 2009 as stocks have been climbing the proverbial “wall of worry” and risen roughly 2,200 points or more than fourfold. While the correlation between the bond spread and the SPX may be spurious, it has been ongoing in both rising and falling markets for the better part of the past 25 years. The rationale would be that higher relative yields attract capital to U.S. shores and vice versa and some of that capital gets parked inevitably in U.S. stocks. Another reason behind the past decade’s widening of the bond spread is that U.S. return on capital (ROC) has been significantly higher than euro area ROC. Currently, there is tentative evidence that this bond spread has crested and at least from a tactical perspective some caution is warranted in the SPX.

Overweight This week and last have witnessed the cavalcade of U.S. banks reporting earnings. A headwind in this earnings season has been the transitory impacts of volatility, which was suppressed in Q1, on fixed income and equity trading earnings that have torqued earnings up and down. While each firm has its own idiosyncrasies and exposure to trading gains or losses, a common theme has been the expansion of net interest margins (NIMs), the measure of profit from the core lending activity, despite the 10-year yield falling throughout the first quarter. In fact, this theme is not new as NIMs have been expanding since bottoming in early-2015, regardless of the ebbs and flows of rates. One key reason for wide NIMs is that banks have not been passing higher rates on to the consumer, despite the Fed’s tightening cycle, thus cementing cheap deposit funding. In the past, NIMs have been reliable indicators of banks’ relative performance but the GFC changed that. The radioactive nature of the sector post-GFC meant that banks did not respond to the recovery of NIMs to pre-crisis levels. However, times have changed; U.S. banks are exceptionally well capitalized and the current divergence between resilient and rising NIMs and flat bank relative performance has opened an exceptional buying opportunity. Bottom Line: Stay overweight banks (and remove the downgrade alert) and stay tuned for our April 22nd Weekly Report where we will be offering a more fulsome update on the sector.

Overweight A little over a year ago we moved to the sidelines in the S&P managed health care index, crystalizing significant relative profits of 28% for our U.S. equity portfolio.  Now the time has come anew to explore this niche health care index from the long side and yesterday we moved to an overweight position. Leading indicators of health care insurance profit margins are currently flashing green. Not only are medical costs melting including drug price inflation (second & bottom panels), but also industry cost structures are kept at bay with wages climbing below a 2%/annum rate growth and trailing overall wage inflation (third panel). On the demand front, as the economy is running at full employment, with unemployment insurance claims probing 60-year lows and with wages representing a headache for small and medium business owners, enrollment should stay healthy. Most importantly, the combination of decreasing medical cost inflation and a healthy overall labor market heralds a steep decline in the industry’s medical loss ratio. While risks of a potential “Medicare For All” plan remain nebulous and have clearly weighed on industry stock prices, melting medical cost inflation, BCA’s rising interest rate expectations along with an economy running at full steam, all suggest that managed health care margins and profits will overwhelm in the coming quarters. Bottom Line: We boosted the S&P managed health care index to overweight yesterday; please see Monday’s Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, ANTH, HUM, CNC, WCG.